Seller of target receiving privately held buyer stock failed to allege facts that established that buyer’s alleged fraud caused seller’s economic loss

Target is a Dallas based technology-consulting limited liability company and was owned by Sellers. Buyer is a technology services company then based in Jacksonville, Florida, and then owned by Buyer’s Owners. Buyer is privately held and not publicly traded.

In the summer of 2012, Sellers began marketing Target for sale through an investment banker and a transactional lawyer. Shortly thereafter, Sellers began negotiating the sale of Target with representatives from Buyer. During the negotiation and closing of the transaction, Buyer’s Owners consisted of its CEO, COO and Tom.

Sometime in the summer or fall of 2012, Sellers claimed they were told that Tom would be Buyer’s CFO. Tom became Buyer’s CFO and signed an employment agreement with Buyer on or around December 28, 2012.

The employment agreement specified Tom would receive a severance payment (about $1 million) if he resigned as CFO (under what the agreement called an involuntary termination) if he determined that his relationship with Buyer had so deteriorated so as to make performance of his responsibilities impossible or impracticable. Under the agreement Tom must notify Buyer of his resignation. Buyer then has 30 days to fix the problem, and if it is not fixed to Tom’s reasonable satisfaction, he would receive a roughly a $1 million severance payment.

In the months leading up to the close of the purchase agreement, Tom’s relationship with Buyer’s CEO and Buyer deteriorated. This seemed to be because Tom was not being paid. On June 5, 2013, Tom sent written notice to Buyer’s CEO stating that he was resigning under the above involuntary termination provision of the employment agreement; which triggered a 30 day cure period and a large severance payment.

The deal closed during the 30 day period Buyer had to cure the problem. Buyer purchased Sellers’ interest in Target in exchange for $3.15 million cash, stock in Buyer, and other compensation.

Buyer did not tell Sellers that Tom had resigned as CFO prior to the closing. In fact, Buyer’s Owners caused Buyer to represent and warrant in the purchase agreement that each of its financial statements disclosed in the transaction had been prepared in accordance with generally accepted accounting principles and fairly presented, in accordance with generally accepted accounting principles, the financial position, results of operations and cash flows of its business of Buyer. Buyer’s Owners also caused Buyer to warrant in the purchase agreement that Buyer did not have any liability except for liabilities disclosed in its financial statements and disclosure schedules.

The financial statements did not disclose the severance liability. Sellers’ accounting expert said that generally accepted accounting principles would require that at least some of the $1M severance payment be included on the financial statements furnished to Sellers before the closing, even though the closing occurred during Buyer’s 30 day period where Buyer could try to fix the problem.

Sellers sued Buyer’s Owners in a Dallas federal district court for federal securities fraud for loss in the value of their Buyer stock. Sellers claimed that Buyer’s Owners’ failure to tell Sellers before the closing that Buyer’s CFO had resigned, which would have required Buyer to report a significant part of the $1 million severance liability on Buyer’s preclosing balance sheet. Sellers claimed that this was an omission of a material fact which resulted in an economic loss to Sellers.

Buyer’s Owners challenged Sellers’ case by way of a motion for summary judgment claiming that the facts alleged by Sellers, even if true, did not make out a federal securities fraud case against Buyer’s Owners.

The court agreed with Buyer’s Owners. The court said that Sellers sufficiently alleged facts that Buyer’s Owners failed to disclose to Sellers a material fact, when it did not disclose the Buyer CFO resignation and when it failed to accrue a severance liability on Buyer’s preclosing balance sheet.

The court conceded that if Sellers had known that information they might have refused to go through with the deal or demanded a higher purchase price. Nevertheless, for Sellers to prevail in a federal securities fraud case, Sellers would have had to allege facts that would establish that it suffered economic loss from the result of Buyer’s Owners’ failed disclosures. This, the court concluded Sellers failed to do. Buyer’s value in the court’s words “collapsed” but Sellers failed to tie the loss in Buyer’s value to the CFO resignation or the severance liability.

The court recognized that Sellers had a tough burden since the Buyer stock is not publicly traded. If for example, Buyer’s stocks were publicly traded securities on an efficient market, and after the closing Buyer made a corrective disclosure telling the market that their CFO had resigned before the closing and the stock price swooned, then Sellers could tie the preclosing undisclosed CFO resignation to the drop in the Buyer stock held by Sellers at the time of the corrective disclosure.

This case is referred to O’Connor v. Cory, Civil Action No. 3:16-CV-1731-B, United States District Court, N.D. Texas, Dallas Division, (January 3, 2019).

Comment. A buyer of a company must remember that if it is using some of the buying company’s stock or other equity as part of the purchase price, then it is selling buyer’s business to the seller as much as buyer is buying a seller’s business from the seller.

In that case, the seller is going to want representations and warranties from the buyer about the buying company. Furthermore, in such a deal, the buyer and top management run the risk of being sued by the seller for fraud under federal and state securities laws, if the buyer’s stock in the hands of the seller goes south.

In 20/20 hindsight, Buyer’s top management would have saved themselves a lot of grief had they told Sellers about the CFO resignation before closing.

By John McCauley: I help people start, grow, buy and sell their businesses.

Email: jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

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Posted in buyer's stock as currency, federal securities fraud, financial representation and warranty, purchase price, representations and warranties, stock purchase agreement, tying fraud to economic loss

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